NOVEMBER
2006 - Most investors and creditors have an image of accountants
as professionally careful and conservative. Even recent accounting
scandals are viewed as an aberration that will be addressed
by changes in law, oversight, and penalties. This benign,
conservative view of accountants may change as the real meaning
of Enron becomes clearer with time. The last 30-odd years
have produced a paradigm shift in corporate accounting theory.
The new theory assumes that the 412-year-old “accounting
model” is broken and must be replaced by an “economically
satisfying” method for valuing assets and liabilities.
Implementation of economic valuation techniques requires that
accountants abandon traditional accounting principles (historical
cost accounting, conservatism, and matching of costs and revenues).
Yet, the movement toward fair value accounting (the general
name for economic valuations) has been undertaken without
evidence that the valuations produced are actually “better”
than the old valuations. In contrast, recent evidence indicates
that use of fair valuation has the potential for spectacularly
misleading results.

FASB
recently adopted SFAS 157, Fair Value Measurements.
The purpose of SFAS 157 is to provide guidance on how to
measure fair value, and “applies under other accounting
pronouncements that require or permit fair value measurements.”
It provides for exceptions such as for share-based payment
transactions and for practicability. FASB defines fair value
as “the price that would be received to sell an asset
or paid to transfer a liability in an orderly transaction
between market participants at the measurement date.”
The fair value should be thought of as an “exit price”
that can apply to assets or liabilities on a standalone
basis, as “a group, a reporting unit, or a business.”
Fair value derives from “a hypothetical transaction
at the measurement date … A fair value measurement
assumes that the transaction to sell the asset or transfer
the liability occurs in the principal market for the asset
or liability or, in the absence of a principal market, the
most advantageous market for the asset or liability. The
principal market is the market in which the reporting entity
would sell the asset or transfer the liability with the
greatest volume and level of activity for the asset or liability.
The most advantageous market is the market in which the
reporting entity would sell the asset or transfer the liability
with the price that maximizes the amount that would be received
for the asset or minimizes the amount that would be paid
to transfer the liability.”

SFAS
157 defines “inputs” into various valuation
techniques as “the assumptions market participants
would use in pricing the asset or liability, including assumptions
about risk.” Inputs may be:

Observable inputs “reflecting the assumptions
market participants would use in pricing the asset or
liability developed based on market data obtained from
sources independent of the reporting entity.”

Unobservable inputs “reflecting the reporting
entity’s own assumptions about the assumptions market
participants would use in pricing the asset or liability
developed based on the best information available in the
circumstances.”

SFAS
157 then establishes a hierarchy of fair value measurements
for financial disclosure. The hierarchy is intended to convey
information about the nature of the inputs (the assumptions,
not the valuation techniques) used in creating the
reported fair values.

Level 2 inputs include “quoted prices for similar
assets and liabilities in active markets[,] … quoted
prices for identical assets and liabilities in markets
that are not active …[,]” observable market
data that are not prices (yield curves, volatilities,
payment spreads, default rates, etc.), or evidence corroborated
by correlation with observable market data.

Level 3 inputs are “unobservable inputs …
Therefore, unobservable inputs shall reflect the reporting
entity’s own assumptions about the assumptions that
market participants would use in pricing the asset or
liability … Unobservable inputs shall be developed
based on the best information available in the circumstances,
which might include the reporting entity’s own data.
In developing unobservable inputs, the reporting entity
need not undertake all possible efforts to obtain information
about market participant assumptions. However, the reporting
entity shall not ignore information about market participant
assumptions that is reasonably available without undue
cost and effort.
Therefore, the reporting entity’s own data used
to develop unobservable inputs shall be adjusted if information
is reasonably available without undue cost and effort
that indicates that market participants would use different
assumptions.”

Enron
made extensive use of what it called “mark-to-market”
accounting. Enron’s mark-to-market—actually,
“mark-to-estimate”—practices would have
fallen into the income approach for valuation using unobservable,
i.e., Level 3, inputs under SFAS 157. References to “fair
value accounting” in the remainder of this article
depend on Level 3 inputs and not Level 1 or Level 2.

This
article will assess the impact of fair valuation on Enron’s
financial statements, question the hoped-for results from
widespread adoption of fair value accounting, and urge rule
makers to prove the usefulness of sweeping changes in accounting
standards. The principal complaint about historical cost
accounting is that it often understates the value of corporate
assets, as well as of equity and income. Convervatism, a
long-standing and pervasive property of financial reporting,
has always placed greater focus on the concern of financial
performance being overstated. Careful, conservative investors
(hereafter, including creditors as well) must be advised
of the potential risks when the new accounting theory is
applied by aggressive corporate managers.

Enron:
A Case Study in Fair Value Accounting

The
earliest revelations about Enron indicated that the company’s
financial statements were seriously misleading. When the
company announced massive write-offs and restatements in
October and November 2001, it seemed that fraud must have
been involved. As the Enron story unfolded, it was revealed
that the company had pursued so many accounting artifices
in its financial reporting that “its financial statements
bore little resemblance to its actual financial condition
or performance” [“Third Interim Report of Neal
Batson, Court-Appointed Examiner,” U.S. Bankruptcy
Court, S.D.N.Y., In re: Enron Corp., et al., Debtors,
Chapter 11, Case No. 01-16034 (AJG), Jointly Administered,
June 20, 2003]. It could even be argued that Enron resembled
an organized crime syndicate; efforts to mislead investors
required the coordinated efforts of many people. As a result
of their combined efforts, equity losses to Enron shareholders
were $65 billion and losses to creditors will be $51 billion.
Although nearly 20 individuals have been charged with crimes,
penalties for some former employees have been disappointing
in light of the massive harm that resulted from Enron’s
failure. Prosecutors may have judged that favorable plea
arrangements could be justified by the ultimate convictions
of the two really big targets: former CEOs Ken Lay and Jeffrey
Skilling.

Lay
and Skilling had a unique strategy in preparing for their
criminal trial. The Wall Street Journal carried
a page-one story titled “An Audacious Enron Defense:
Company’s Moves Were All Legal” (John R. Emshwiller,
January 20, 2006). A principal contention of the prosecution
was that Enron hid losses through improper and misleading
use of special-purpose entities (SPE) and outside partnerships;
however, the defense was prepared to argue that “Enron’s
use of the entities met all necessary accounting and legal
criteria.”

It
is important to emphasize that Lay and Skilling did not
plan to claim that: a) they “didn’t understand”
the accounting; b) they “didn’t know”
that the accounting was misleading; or c) that subordinates,
acting on their own, were responsible. Their attorneys’
strategy was to argue, “[W]ith a few irrelevant exceptions,
there were no crimes at Enron … [N]either their clients
nor almost all of those former Enron executives who have
pleaded guilty did anything illegal” (John R. Emshwiller
and Gary McWilliams, “Enron Defense: What Crimes?:
Lawyers for Lay, Skilling Set Off on Tricky Tack of Challenging
Underlying Guilt Set in Plea Deals,” Wall Street
Journal, February 6, 2006). Effectively, Lay and Skilling
were willing to admit that they fully understood the accounting
rules, they understood the picture of Enron that these rules
presented to investors, and they (and their subordinates)
intentionally applied the accounting rules to their logical
conclusion.

Enron’s
use of SPEs is not the only accounting practice that deserves
scrutiny. Enron also made extensive use of fair value accounting
(see Bethany McLean and Peter Elkind, The Smartest Guys
in the Room, Portfolio, 2003). Despite its likely overstatement
of fair value assets, Enron’s use of fair value accounting
was never an issue in the criminal case against Lay and
Skilling. Eugene H. Flegm’s forthright article (“Accounting
at a Crossroad,” The CPA Journal, December
2005) called attention to the importance of fair value accounting
at Enron: “Surprisingly, no regulatory body, including
Congress or the SEC, has criticized FASB for its part in
enabling frauds … It is my belief that FASB pursues
the fair-value measurement base out of hubris.” Enron
certainly has raised some questions.

How
Important Was Fair Value Accounting to Enron’s Misleading
Financial Statements?

Because
of Enron’s swift and dramatic default, it is worthwhile
to try to isolate and measure exactly what was “wrong”
with its financial statements—what made them misleading.
One way to do this is to investigate how various changes
in Enron’s financial statements might have affected
the way the company was perceived by investors. The risk
of default is a central focus for most creditors and many
equity investors. For example, bond ratings carry implications
for the probability of default. Exhibit
1 presents the historical one-year average default experience
associated with the ratings issued by Standard & Poor’s
Corporation and Moody’s Investors Service.

Enron’s
senior unsecured bond ratings are shown in Exhibit
2. S&P rated Enron BBB+ from 1995 through late 2001
(Exhibit Series 1). Moody’s (Series 2) rated the company
Baa2 until March 2001, when the rating improved to Baa1.
These ratings are considered “investment grade”
and they communicated the agencies’ belief that Enron
had much-lower-than-average default risk (i.e., about one
quarter of the average risk for all U.S. corporations).
The ratings help illustrate how misleading Enron’s
financial statements were. Long-term credit ratings generally
depend on financial statement information such as the relationship
of debt to equity, liquidity, and profitability. Because
bond ratings also incorporate subjective information (e.g.,
analyses of management, markets, and competition), it is
difficult to know exactly how much different (lower?) these
ratings might have been with “correct” financial
statements.

The
most frequently criticized accounting issue at Enron was
the company’s use of off–balance-sheet financing.
Regarding Enron’s use of “SPEs and aggressive
accounting practices,” Neal Batson, the court-appointed
examiner-in-bankruptcy for Enron, concluded the following
in his report:

Although
evidence suggests that Enron’s financial engineering
began years earlier, the Examiner focused on 2000, the
last year for which Enron issued audited financial statements.
That year, Enron’s use of six accounting techniques
produced 96% of its reported net income and 105% of its
reported funds flow from operating activities, and enabled
it to report $10.2 billion of debt rather than $22.1 billion
of debt.

This
suggests that an adjusting entry could be used to recast
the 2000 financial statements. Because the impact of the
adjusting entry on S&P’s and Moody’s ratings
cannot be measured directly, an alternative approach would
be to devise a mechanical credit-rating model that uses
only financial statement information. The mechanical credit
rating can first be calculated using the original financial
statement data and then re-estimated after posting the hypothetical
adjusting entry. Any change in rating would serve as an
estimate of the impact that changes in financial information
might have had on bond ratings.

This
can be accomplished using the well-documented proprietary
Zeta credit risk model, which combines variables that measure
traditional credit-rating concepts of capital structure,
liquidity, profitability, debt service capacity, and predictability
of income flow. Series 3 in Exhibit 2 shows the historical
record of Zeta credit ratings. These ratings use only Enron’s
originally reported financial information. In 2000 and 2001,
the base Zeta bond rating was equivalent to BBB-/Baa3 (slightly
lower than S&P and Moody’s, but still investment
grade). Series 3 provides a base of comparison for proposed
adjustments to the financial statements.

The
next step is to demonstrate what effect the bankruptcy examiner’s
proposed adjustments might have had on Enron’s credit
rating. Series 4 in Exhibit 2 shows how the Zeta bond rating
would change after posting Batson’s suggested adjusting
entry to Enron’s financial statements. (The entry
increased assets by $4 billion, reduced other liabilities
by $4 billion, reduced minority interest by $1 billion,
reduced equity by $3 billion, and increased debt by $12
billion.) The adjusted Zeta rating in late 2001 would have
been BB/Ba2.

Note
that the ratings in Series 4 don’t fully explain the
company’s astonishingly rapid failure. A rating of
BB/Ba2 is considered less-than-investment-grade, but it
still has a lower risk of default than an average U.S. corporation.
It certainly does not reflect the very-high risk profile
that Enron in retrospect demonstrated. The outlook for Enron’s
creditors is bleak. The bankruptcy plan is expected to generate
only $12 billion to satisfy $63 billion in claims. After
posting the examiner’s adjustments, Enron’s
total assets would have been $70 billion, enough to satisfy
outstanding creditor claims. According to bankruptcy court
filings, the $12 billion in funds available for recovery
will be derived primarily from the sale of Enron’s
power-generating and gas-transmission utility businesses.
What about the other $58 billion in assets? Something besides
the recognition of off–balance-sheet debt is required
to explain Enron’s dramatic loss of value.

The
most obvious explanation is that the balance sheet contained
“assets” that had little or no value. Most of
the asset captions on Enron’s 2000 balance sheet look
quite ordinary: cash ($1 billion), trade receivables ($10
billion), inventories ($1 billion), deposits ($2 billion),
goodwill ($3.6 billion), property, plant, and equipment
($12 billion). These assets alone would appear to be worth
more than the amount creditors will realize (although security
analysts frequently discount the value of goodwill). Some
or all of these assets may have been overvalued, but it
does not look as though these accounts should have given
Enron’s independent auditor much difficulty.

Enron’s
balance sheet also included current and noncurrent accounts
captioned “price risk management assets” (PRMA).
These were Enron’s fair value accounting assets. Skilling
and Enron persuaded the SEC in January 1992 that Enron should
be able to use mark-to-market accounting to value long-term
gas contracts and derivatives (McLean and Elkind). Thus,
the SEC handed Enron the tools to abandon traditional principles
and introduce the bookkeeping analogue of financial engineering
into nonfinancial companies. Enron eagerly applied the tools
and soon began discounting to present value as much as 29
years of income from customer contracts. The result, after
considerable manipulation, was instantaneous increases in
assets and offsetting equity and, of course, income. By
2000, Enron’s PRMA amounted to $21 billion (31% of
reported assets), quadruple their 1999 carrying value ($5
billion, or 15% of reported assets).

The
next step in unraveling Enron’s accounting is to calculate
the effect that PRMA might have had on investors’
perceptions. Absent any other reasonable explanation as
to why Enron’s assets lost so much value in bankruptcy,
McLean and Elkind tested the idea that PRMA never had any
value. The author wrote off Enron’s PRMA year by year
from 1992 through 2000. This is arbitrary treatment, but
it is intended to demonstrate the magnitude by which fair
value accounting affected Enron’s financial statements.
Series 5 in Exhibit 2 shows the effect on Enron’s
Zeta credit ratings during the period. Note that these revised
numbers also include the Examiner’s adjustments in
2000 and 2001. From 1992 through 1999, these adjustments
resulted in an average rating reduction of about one notch.
In 2000, however, the year in which Enron’s PRMA ballooned
from $5 to $21 billion, the adjusted Zeta rating would have
yielded B+/B1. A rating of B+/B1 would have alerted the
public that Enron’s probability of default was about
three and a half times higher than that of the average U.S.
corporation.

Enron’s
use of PRMA very likely obscured the depth of its problems.
In light of the fact that virtually all of the recovery
to creditors will come from the sale of electric and gas-transmission
utility assets, it is tempting to speculate that these were
the only Enron businesses that had any value. Obviously,
shrinkage of asset values is a common problem in bankruptcy,
but it looks as though Enron was never much more than a
simple utility company.

The
larger question here is the relative importance of off–balance-sheet
debt and PRMA in Enron’s financial statements. The
bankruptcy examiner’s discovery of off–balance-sheet
debt was material and would have reduced Enron’s credit
rating by about one notch, using Exhibit 2’s Zeta
analysis in 2000. The additional step of removing the highly
questionable PRMA would have lowered the rating an additional
three notches. The use of fair value accounting should probably
receive more blame for Enron’s misstated financials
than the use of SPEs.

Not
only did fair value accounting probably contribute more
to Enron’s collapse than SPEs did, but it was also
partially responsible for Enron’s decision to use
them. George Benston noted, “Although mark-to-fair-value
accounting allowed Enron to record substantial profits,
it did not provide cash flow. Enron had to deal with analysts
who were suspicious of accounting net income and looked
to cash flow as a superior measure of performance …
Enron attempted to bring these alternative performance measures
into balance, as well as obtain cash for its operations
and projects without having to sell stock or report debt,
primarily with four [off–balance-sheet debt] schemes”
[George J. Benston, “Fair-Value Accounting: A Cautionary
Tale from Enron,” Journal of Accounting and Public
Policy, 2006 (forthcoming)]. Batson, the bankruptcy
examiner, concurred: “Enron’s use of mark-to-market
… accounting created a timing gap between recognition
of net income and the receipt to associated cash. This ‘quality
of earnings’ problem made it particularly challenging
for Enron to raise cash without issuing equity while maintaining
its credit rating.” Enron used the SPEs to cover up
the cash flow gap created by fair value accounting “income.”

Lay
and Skilling’s criminal trial is over. Apparently,
the prosecution decided to deemphasize accounting issues,
but the analysis of the misleading aspects of Enron’s
financial statements suggests that a surreal defense might
have been available to the defendants. If they had been
more realistic about their claims regarding the financial
statements, they might have been able to deflect much of
the responsibility through the following argument: “The
SPEs were legal, but even if they weren’t legal, SPEs
and off–balance-sheet financing techniques cannot
be blamed for misleading investors, because they were barely
material. What really misled investors was the far more
material accounting for fair value assets that was approved
by the SEC.”

Are
Investors Served by Widespread Implementation of Fair Value
Accounting?

For
most financial statement users (whether they invested in
Enron or not), the company’s reporting was unintelligible.
A few investors who consciously avoided Enron may have done
so because they understood what the company was doing. More
of those who avoided it did so, in this author’s opinion,
because they couldn’t understand the accounting. It
is probable that no amount of additional disclosure would
have rendered Enron’s complex transactions sensible
even to reasonably sophisticated investors. The value to
investors of forward-looking fair value accounting is questionable.

While
investors will always be vitally interested in what is likely
to occur in the future, more than anything else they need
an accurate record of what has happened in the past. At
its best, fair value accounting does not provide this. Instead,
Benston noted, “the practice of public accounting
has become similar to tax practice, with clients demanding
and accountants providing expertise on ways to avoid the
substantive requirements of GAAP while remaining in technical
compliance.” [“The Quality of Corporate Financial
Statements and their Auditors Before and After Enron,”
Policy Analysis, No. 497, November 6, 2003. Benston
was writing about rules-based GAAP, but it is clear that
his comment is also applicable to fair value accounting.]
Bentson also commented: “What [accounting authorities
(SEC, FASB, IASB)] do not appear to recognize sufficiently
is that numbers that are likely to be manipulated by opportunistic
or overoptimistic managers are considerably worse for investors
than numbers that are not current. Consequently, the authorities
have required fair values, at least for financial assets,
even when they are not based on reliable market values.”

What
Does Fair Value Accounting Mean for Market Efficiency?

The
traditional model for dissemination of financial information
follows a certain path:

A critical
element of this process is the presentation of independently
verified financial statements to security analysts. Hundreds,
perhaps thousands, of security analysts in turn use their
best efforts to model or value a company. Market efficiency
results from the collective efforts of many analysts assessing
a relatively objective set of financial statements.

Broad
implementation of fair value accounting will change the
dissemination of financial information, which will proceed
along the following path:

FASB,
knowingly or not, is pushing to change the role of the independent
accountant from objective reviewer of financial information
to subjective valuation specialist. Accountants will become
both judge and jury regarding financial valuation. The role
of security analysts in creating market efficiency will
be dramatically reduced because they will be receiving a
highly processed end-product based on thousands of assumptions
by a single firm about a company’s future. Even if
independent accountants have no intentional bias, the capital
allocation formula will transform from a review by many
analysts to a review by a single analyst. Independent security
analysts are unlikely to have access to all the accountants’
assumptions.

Benston
proposes a solution: “[F]air values could be presented
to investors in supplementary schedules and even attested
to by [independent public accountants] as having been derived
from models or sources that [they] find acceptable.”
Security analysts would retain the historic baseline, but
would have access to projected data. After that, markets,
not independent accountants, would determine the meaning
of the additional data.

Who
Will Be Responsible for the Failures of Fair Value Accounting?

The
American Assembly, a nonpartisan public affairs forum affiliated
with Columbia University, recently sponsored a study titled
“The Future of the Accounting Profession” (see
www.americanassembly.org).
For more than two years, a blue-ribbon steering committee
sought “to determine whether America’s current
‘accounting model’ was able to deal effectively
with contemporary business practices.” According to
Robert Bloom, the committee’s report:

[S]tresses
the subjectivity and judgmental nature of financial statements
… The public, not to mention audit committees, may
be calling for a degree of certainty in audits and accounting
that cannot be achieved … The participants recommended
that auditors exercise judgment to a greater extent …
The report forecasts that the balance sheet of the future
will include assets reflecting alternative valuation methods
… The participants contend, in perhaps the report’s
most significant recommendation, that auditors, who have
to make many judgments and form subjective opinions, need
to be protected from legal exposure; therefore, their
liability ought to be limited. [Robert Bloom, “‘The
Future of the Accounting Profession’ Report,”
The CPA Journal, November 2005]

The
American Assembly, with its reference to “assets reflecting
alternative valuation methods,” seems to endorse FASB’s
commitment to expand fair value accounting. The committee
emphasized that accounting methods are subjective and, consequently,
accountants must be shielded from liability when required
to provide subjective analyses. Yet
the committee doesn’t seem to appreciate that independent
accountants are not passive bystanders of subjectivity in
financial statements. The accounting profession increases
its own vulnerability as its standards progress toward the
increased application of Level 3 fair value accounting.
It drives itself toward ever greater subjectivity!
Fair value accounting is turning corporate financial reporting
into speculation about future events and forcing independent
accountants to speculate about whether a corporation’s
speculations are “reasonable.”

Bloom
characterizes the call to limit accountants’ liability
for subjective application of accounting rules the committee’s
“most significant” recommendation. Perhaps he
should have called it the most stunning recommendation.
Is no one going to be held responsible for the next Enron?
If auditors are required to create financial statements
that don’t make sense, should they be held responsible
when their clients fail without warning? Of course not.
On the other hand, no standards setter, regulator, or academic
body has offered to accept responsibility for materially
flawed accounting standards. In the end, increasingly subjective
financial statements, combined with insulation from liability,
will make it nearly impossible to hold anyone accountable
for the inevitable opportunistic bookkeeping.

Earlier
in these pages, Walter P. Schuetze pioneered new ground
for evading responsibility for financial statements (“In
Defense of Fair Value Accounting,” The CPA Journal,
February 2006). Schuetze called for fair-valuation “in
all balance sheets for all assets and liabilities as soon
as possible.” However, he freely admitted that “CPAs
are neither qualified nor competent to judge fair-value
amounts ascribed to noncash assets and liabilities.”
This dilemma is to be solved by reliance on valuations from
outside specialists. As far as Enron was concerned, Schuetze
(the SEC’s Chief Accountant at the time it approved
Enron’s use of fair value accounting) does not view
the approval of fair value accounting as having been a regulatory
failure. He sees the regulatory error as failing to require
“Enron to get [valuation] opinions from outside, independent
valuation experts.” Schuetze seems to acknowledge
that Enron misstated its fair value assets, but minimizes
the problem as merely one of degree. By his reckoning, outside
experts would have corrected (i.e., lowered) the valuations.

Schuetze
has commented elsewhere about mark-to-market accounting
(“Accounting that Adds Up: Testimony of Walter P.
Schuetze before the United States Senate Committee on Banking,
Housing, and Urban Affairs,” The CPA Journal,
April 2002). Unlike academics who use the perceived understatement
of corporate net assets (relative to market equity values)
to justify fair value accounting, the thrust of Schuetze’s
congressional testimony was that mark-to-market accounting
can reduce the overstatement of net assets in cases like
Enron. He argues that historical cost accounting and the
current impairment standard are not adequate for this purpose,
citing several examples where specific assets should have
been marked down using mark-to-market valuations. Conceptually,
I have no quarrel with these examples, but they are relatively
straightforward valuations where market (Level 1) or near
market (Level 2) prices exist. Assets that fall under FASB’s
Level 3 proposal are a different matter.

Enron
invented whole businesses—including trading desks,
fixed assets, and capitalized software—in order to
create and maintain Level 3 PRMA. These businesses never
had any real business purpose, and never created tangible
cash benefits for shareholders. Their purpose was to manipulate
into current years as much speculative future income as
they could, so that management could profit from their incentive
compensation agreements. It would have been nearly impossible
for any outsider to call these businesses, employing thousands
of workers, worthless, especially because the SEC said it
was all legal. There is no guarantee that Enron’s
financial statements would have been different if its auditors
had used outside valuation specialists. How could a valuation
consulting firm have had more leverage over Enron than its
independent auditor?

Judging
by Enron’s asset recovery experience, it is likely
that Enron’s PRMAs were worthless from the day their
use was approved and should never have been permitted at
all. Until now, the accountants could blame only management,
and vice versa. Schuetze’s proposal would shift responsibility
for a flawed accounting concept onto “experts”
and promises an era of endless finger-pointing in the wake
of the next corporate failure. In the case of Enron, Andersen
might still exist under such a regime, because the subsequent
investigation would have focused on the valuation “experts.”

When
Will We Have Proof That New Accounting Rules Are Better
for Investors?

This
final question may be the most important. For more than
30 years, FASB has developed new accounting standards, guided
by its “conceptual framework” for accounting.
Enormous effort has gone into re-evaluating every aspect
of accounting, but this may be overthinking the problem.
In this author’s opinion, many accounting changes
have been reasonable (e.g., the capitalization of financing
leases and the consolidation of captive finance companies),
while other changes have produced awful results (e.g., pension
accounting). Others may disagree. Accounting
changes are expensive to implement and audit, but all accounting
standards share the same problem: No one knows if they have
made a difference in the utility of financial statements
for investors. There is usually vigorous argument about
a new standard before it is made effective. Yet there is
no effort, before an accounting release or after, to collect
verifiable evidence that the new standard allows investors
to better invest their capital, or creditors to better quantify
default risk. After a crisis, investors and creditors are
told that misleading results couldn’t have been foreseen,
and legislators are asked to shield independent accountants
from liability.

A more
important goal for accounting than a conceptual framework
is developing a way to collect evidence that shows whether
changes in accounting standards allow investors to make
better judgments about future performance. This author is
not sure what the measure of effectiveness for new accounting
rules should be, but FASB should be trying to solve that
problem. In 1966 renowned accounting professor and researcher
William Beaver proposed that prediction of business failure
(i.e., bankruptcy or default) might be a reasonable metric
for evaluating the effectiveness of accounting alternatives
(“Financial Ratios as Predictors of Failures,”
Journal of Accounting Research, Vol. 4, Empirical
Research in Accounting: Selected Studies 1966). Other
authors have proposed links between accounting information
and stock market values (George Benston, “Published
Corporate Accounting Data and Stock Prices,” Journal
of Accounting Research, 1967; Ray Ball and Philip Brown,
“An Empirical Evaluation of Accounting Income Numbers,”
Journal of Accounting Research, Vol. 6, No. 2, 1968;
and James A. Ohlson, “Earnings, Book Values, and Dividends
in Equity Valuation,” Contemporary Accounting
Research, Vol. 11, No. 2, 1995). If a satisfactory
metric can’t be found, how can changes to accounting
standards be justified? Without any evidence of usefulness,
Flegm may be correct: “FASB pursues the fair-value
measurement base out of hubris.”

Measuring
the Value of Accounting Standards

A very
material portion of Enron’s assets were fictional
by any reasonable definition of the word “asset,”
even though much of what Enron did was approved by the SEC
and may have been consistent with evolving GAAP. Accounting
theory is undergoing a major conceptual change, and the
most recent manifestation—the application of Level
3 fair value accounting under SFAS 157—has the potential
for widespread deception of investors.

Issuers
of corporate securities ask investors to trust them with
their money. Financial statements provide the vehicle through
which companies communicate to investors what has been done
with that money. This is no theoretical exercise and should
not be treated as one. I believe that until FASB can produce
evidence of its value, the fair value accounting project
should be limited to footnote or schedule disclosures. Otherwise,
investors must become even more skeptical of accounting
information than they now are, and questions about the quality
of earnings will possess greater urgency.

Robert
G. Haldeman, Jr., CPA, is president of Zeta Services
Inc., Mountainside, N.J. Author’s
Note: The opinions expressed herein are my own. I
would like to thank Joe Welchoff, George Benston, Ed Savage,
Eugene Flegm, Jim Byrd, Jeffrey Feldman, and Marty Fridson
for their comments on previous drafts. All remaining errors
are my own.

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